Thursday, November 18, 2010

Fundamentally Speaking, Now is a Confusing Time

Quantitative easing (QE 2) has begun and the markets are pretty confused, based on volatility of commodity prices and daily currency exchange swings, and the VIX. It's a terrible time to try forecasting a market's direction amidst all the financial situations around the world (Ireland banks, China inflation, Yen direction, euro direction, US$ direction) as well as the economic influence of QE 2 operations. There is also speculation about the process the Fed has chosen for it's QE 2 plan and whether it will be successful soon, if ever. An interesting observation of the plan is described in "They Just Don't Get It", written by Paul Kasriel.

Kasriel observes that the Fed is targeting the middle-term sections of the maturity spectrum, avoiding the bill's, or short-term issues. He contends that the Fed may have to deliver more easing until they can move the needle of credit outstanding up. He writes "The Federal Reserve has the unique ability to be able to create credit
figuratively "out of thin air." So does the commercial banking system,
if the Fed provides the "seed money." The ability to create credit out
of thin air implies that the recipients of that credit can increase
their current spending without any other entity in the economy having to
cut back on its current spending. Chart 4 (use link to article above) shows that combined Federal
Reserve and commercial banking system credit have recently contracted at
an unprecedented rate. The rate of contraction is slowing. The goal of
QE2 should be to get this credit aggregate growing. If $600 billion of
securities purchases by the Fed does not result in growth in this credit
aggregate, then the Fed could increase the quantity of its securities purchases." The chart from the St Louis Fed below, illustrates most of the point Kasriel makes by illustrating the monthly year-over-year change in total commercial and industrial loans at all commercial banks. Kasriel is usually someone I have thought of as pragmatic. Keep printing! Really?

Click on image to enlarge

The global influence of QE2 is important. Commenting about the global political concerns following the meeting
of G20 finance ministers and the FOMC QE2 anouncement, columnist and
economist Andy Xie describes the global landscape. He makes the
following comments in his opinion article titled, Group Study Questions, for 20.
"The hope was for the G-20 to gang up on China at the Summit. Instead,
it
became a festival of global backlash against the Fed's QE 2." He goes
on to describe his perception of Washington policy making. "When the
U.S.'s best product
idea – the iPhone – doesn't lead to a rise in production at home, one
should be wary of optimistic sound bites.The U.S. government
wants to change the global reality by rearranging the exchange rates. If
this idea works, one must lift the standard of living in countries like
China and India instantaneously to that in developed economies or lower
the U.S.'s living standard to that of China and India's. Neither is
possible. The political atmosphere in the U.S.'s requires solutions that
generate instantaneous effects. The world can't offer that. As long as
the U.S. continues to search for the impossible, the world will be a
dangerous place." Will a weaker dollar be tolerated?

And the municipal bond market represents in the aggregate a big crack in the domestic economic foundation. This is troublesome because muni's were considered a safe haven in an otherwise mixed up credit environment. Financial industry analyst, Chris Whalen, made the following observation regarding the credit crisis in California on Yahoo Tech Ticker recently.
"The state won't immediately default, Whalen says. It will start by
issuing the same sort of IOUs that it issued to buy itself time during
its budget crisis last year. But, eventually, the debts will have to be
restructured, and this will result in those who own California's bonds
receiving less than 100 cents on the dollar.

Why won't California just get a bailout?

Because
the Republicans now control Congress, Whalen says. And also because,
if California gets bailed out, dozens of other states will immediately
line up with their hands out. The public is fed up with bailouts,
Whalen says--and eventually, the country will be forced to face up to
its bad debts and write them off." This too will unravel slowly. Insurance companies, institutional funds and pension plans are in jeopardy.

Long-term trends are anybody's guess. Short-term trends have been reacting to currency swings. The concept of QE2 seems to be built around the "if you build it they will come" theory. What appears to be happening is the general contractor (the Fed) has begun buying and delivering materials to the building site (US economy). The blueprints are spread out on the design table for transparency and they say, The asset purchases will be used in a way that’s “measured
and responsive to economic conditions,” Bernanke said. Sounds like there is something for everybody. Right? Speaking of everybody, did you think there would be concern across Asia over the risk of a flood of capital
that causes asset bubbles from QE2? Would you have guessed economies from Taiwan to Indonesia
and Brazil have taken steps to counter inflows of speculative
money, and South Korea yesterday said it will back legislation
restoring a tax on foreign investment in the nation’s bonds? Why is the cash from QE2 heading away from the target where the stated goal is to manage US inflation at or below 2% and increase employment in the US?

On his blog Cara Community, Bill Cara had these thoughts for his readers that capture this topic in just a few sentences.
"Today’s (November 18, 2010) strong bounce above Dow 11,000 is not a surprise when you consider the ingredients:

-- Another country clean-up job in Europe
-- Jobless Claims report under 450K (3 of the last 4 in that camp)
-- Leading Economic Indicators at impressive levels for another month
-- Philadelphia Fed Survey reading of 22.5 crushing the expectations of only 5.6

Now the question is: does this bounce have legs?

Yes, if economic readings keep coming in like today. And yes, if
corporate earnings keep beating expectations. (Meaning the quality 1-2
punch that got us to Dow 11,000 in the first place).

Unfortunately the answer is No, if a larger European country catches
the Greek/Irish flu. And no, if QE2 doesn’t stave off deflation. And no,
if the 2nd round of bank stress tests are being done because our
nation’s banks are in trouble (again).

The above dichotomy is exactly the problem we are facing as
investors. Everything looks great as long as nothing blows up. Not the
easiest environment in which to construct a portfolio.

The key is to not to be 100% bullish or 100% bearish as those extreme postures can lead to some extremely bad outcomes."

About Scanner

For twenty some years my professional work has been wealth management. This blog began as a tool for some friends and I to organize information/research on a variety of financial topics. Blogging has also helped me to be disciplined about growing my knowledge of finance and investing, both fundamentally and technically. The blog has evolved to be a site for collection of certain data for my friends and I.
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